What is Purchasing Power Parity?
The Purchasing Power Parity (PPP) is a unit of measurement that allows comparison of purchasing power of different currencies. In its calculation, the purchasing power parity does not take into account the exchange rate but the cost of living in general through a basket of goods and services. So, we compare for example the price of a bottle of Coca Cola in France and in the United States.
Unlike the exchange rate that reflects the value of a currency on the market, the PPP emphasizes the intrinsic value to a consumer.
The purchasing power is defined by the capacity of purchase of goods and services that can be obtained from a specific income. This purchasing power is different in each country with the same income. Indeed, the cost of living is not the same everywhere.
Purchasing power parity therefore seeks to compare the different purchasing powers of each country according to the general price level. This is called absolute PPP. This therefore makes it possible to determine the country in which the cost of living is the most expensive.
Absolute PPP = Reference Basket price in t in the domestic country / Reference Basket price in t in the foreign country.
Example: a basket of products is valued at $ 500 in the US and have an average cost of 400 euros in France, so the PPP exchange rate of dollar against the euro is 0.80.
Another measure of the PPP seeks to measure changes in purchasing power between two countries. That is what is known as relative PPP so that is the variation of the purchasing Power Parity between two periods.
Relative PPP = (Reference Basket price in t in the foreign country – Reference Basket price in t-1 in the foreign country) / (Reference Basket price in t in the domestic country – Reference Basket price in t-1 in the domestic country)
Example: a basket of products is valued at $ 500 in the US and has an average cost of 400 euros in France in 2011. In 2010, the same basket had an average cost of $ 480 in the U.S. and 380 euros in France. Then the evolution of exchange rates in PPP of the dollar against the euro is (400/380) / (500/480) = 1.0105%
Uses of the purchasing power parity (PPP)
So, the PPP compares the price levels in different countries according to the standard of living. In other words, the PPP compares the cost of living.
The main advantage is that the purchasing Power Parity reflects an economic reality and so remove the speculative aspect that significantly affects the market exchange rates. Comparisons are possible in the short term. With the market exchange rate, it is better to observed the general trend because due to volatility, there are sudden changes of quotes that they do not appear in the PPP exchange rate.
Besides, the purchasing Power Parity exchange rate allows the comparison with poor countries. Indeed, it is difficult to get an objective view of the evolution of a poor country compared to a rich country (or other poor countries) because currencies of these countries are often undervalued (as unattractive for investor).
Moreover, some of these countries still have a fixed exchange rate. The price of their currency is pegged to the evolution of another currency (usually U.S. dollars). It is impossible to make an assessment of the evolution of living when the exchange rate does not fluctuate. The purchasing power parity allows it.
Limits of the purchasing power parity (PPP)
The purchasing power parity is not a flawless measurement tool. Here are its major’s defaults:
– Depending on the selected goods and services in the basket used for comparison, the purchasing power parity can change dramatically. It is therefore necessary to keep the same basket of goods and services over time in order to make a accurate comparison.
– The products used differ according to each country which has its own habits. It is sometimes difficult to establish a coherent basket to make a good comparison.
– In each country, products may be identical but with different quality. This quality difference is sometimes difficult to judge.
– Prices vary widely within a country (in a city or campaign). It is sometimes difficult to find a basket of goods and services representative of the cost of living in an entire country.
– The PPP is supposed to ignore the evolution of the market exchange rates. But the prices of imported products are very sensitive to changes in exchange rates. So there is a correlation between the exchange rate and PPP exchange rates.
Big Mac index
The Big Mac index was invented by the magazine ‘The Economist’ in 1986. It reduces the measure of the PPP exchange rate to the simple price of a Big Mac. In fact, McDonalds is present in all countries of the world, including the poorest and the price of a Big Mac is an element that compares the cost of living between countries. Read also: Multinational Corporations Role in Foreign Exchange Markets
Moreover, this product contains several factors of economic development of a country that is raw materials (imported or not) and services (cooks, salesmen).
In addition, McDonalds is one of the biggest companies in the world, production costs are up from down (due to their bargaining power). The other big advantage which counters one the default of the PPP is that selling prices are set nationally by the firm.
The price of a Big Mac is in the same in the city or in campaign even if some discrepancies may exist.
The Big Mac index certainly eliminates some defaults of the purchasing Power Parity (ie homogeneity of prices in one country and product quality) but new ones are created:
– The price of a Big Mac is function of the demand for this product. However, some countries consume much less Big Macs in their eating habits and the price of a Big Mac is then more expensive.
– Some countries in order to protect their local market will establish trade barriers (taxes) to limit the introduction of some foreign companies namely McDonalds for example.